What is a 'Hedge Fund'

Hedge funds are alternative investments using pooled funds that employ numerous different strategies to earn active return, or alpha, for their investors. Hedge funds may be aggressively managed or make use of derivatives and leverage in both domestic and international markets with the goal of generating high returns (either in an absolute sense or over a specified market benchmark). It is important to note that hedge funds are generally only accessible to accredited investors as they require less SEC regulations than other funds. One aspect that has set the hedge fund industry apart is the fact that hedge funds face less regulation than mutual funds and other investment vehicles.

BREAKING DOWN 'Hedge Fund'

Each hedge fund is constructed to take advantage of certain identifiable market opportunities. Hedge funds use different investment strategies and thus are often classified according to investment style. There is substantial diversity in risk attributes and investments among styles.

Legally, hedge funds are most often set up as private investment limited partnerships that are open to a limited number of accredited investors and require a large initial minimum investment. Investments in hedge funds are illiquid as they often require investors keep their money in the fund for at least one year, a time known as the lock-up period. Withdrawals may also only happen at certain intervals such as quarterly or bi-annually.

The History of the Hedge Fund 

Former writer and sociologist Alfred Winslow Jones’s company, A.W. Jones & Co. launched the first hedge fund in 1949. It was while writing an article about current investment trends for Fortune in 1948 that Jones was inspired to try his hand at managing money. He raised $100,000 (including $40,000 out of his own pocket) and set forth to try to minimize the risk in holding long-term stock positions by short selling other stocks. This investing innovation is now referred to as the classic long/short equities model. Jones also employed leverage to enhance returns.

In 1952, Jones altered the structure of his investment vehicle, converting it from a general partnership to a limited partnership and adding a 20% incentive fee as compensation for the managing partner. As the first money manager to combine short selling, the use of leverage, shared risk through a partnership with other investors and a compensation system based on investment performance, Jones earned his place in investing history as the father of the hedge fund.

Hedge funds went on to dramatically outperform most mutual funds in the 1960s and gained further popularity when a 1966 article in Fortune highlighted an obscure investment that outperformed every mutual fund on the market by double-digit figures over the past year and by high double-digits over the last five years.

However, as hedge fund trends evolved, in an effort to maximize returns, many funds turned away from Jones' strategy, which focused on stock picking coupled with hedging and chose instead to engage in riskier strategies based on long-term leverage. These tactics led to heavy losses in 1969-70, followed by a number of hedge fund closures during the bear market of 1973-74.

The industry was relatively quiet for more than two decades until a 1986 article in Institutional Investor touted the double-digit performance of Julian Robertson's Tiger Fund. With a high-flying hedge fund once again capturing the public's attention with its stellar performance, investors flocked to an industry that now offered thousands of funds and an ever-increasing array of exotic strategies, including currency trading and derivatives such as futures and options.

High-profile money managers deserted the traditional mutual fund industry in droves in the early 1990s, seeking fame and fortune as hedge fund managers. Unfortunately, history repeated itself in the late 1990s and into the early 2000s as a number of high-profile hedge funds, including Robertson's, failed in spectacular fashion. Since that era, the hedge fund industry has grown substantially. Today the hedge fund industry is massive—total assets under management in the industry is valued at more than $3.2 trillion according to the 2016 Preqin Global Hedge Fund Report. The number of operating hedge funds has grown as well. There were around 2,000 hedge funds in 2002. That number increased to over 10,000 by 2015. However, in 2016, the number of hedge funds is currently on a decline again according to data from Hedge Fund Research.

Key Characteristics of Hedge Funds 

1. They're only open to "accredited" or qualified investors:  Hedge funds are only allowed to take money from "qualified" investors—individuals with an annual income that exceeds $200,000 for the past two years or a net worth exceeding $1 million, excluding their primary residence. As such, the Securities and Exchange Commission deems qualified investors suitable enough to handle the potential risks that come from a wider investment mandate. 

2. They offer wider investment latitude than other funds: A hedge fund's investment universe is only limited by its mandate. A hedge fund can basically invest in anything—land, real estate, stocks, derivatives, and currencies. Mutual funds, by contrast, have to basically stick to stocks or bonds, and are usually long-only.

3. They often employ leverage: Hedge funds will often use borrowed money to amplify their returns. As we saw during the financial crisis of 2008, leverage can also wipe out hedge funds.

4. Fee structure: Instead of charging an expense ratio only, hedge funds charge both an expense ratio and a performance fee. This fee structure is known as "Two and Twenty"—a 2% asset management fee and then a 20% cut of any gains generated.

There are more specific characteristics that define a hedge fund, but basically, because they are private investment vehicles that only allow wealthy individuals to invest, hedge funds can pretty much do what they want as long as they disclose the strategy upfront to investors. This wide latitude may sound very risky, and at times it can be. Some of the most spectacular financial blow-ups have involved hedge funds. That said, this flexibility afforded to hedge funds has led to some of the most talented money managers producing some amazing long-term returns.

It is important to note that "hedging" is actually the practice of attempting to reduce risk, but the goal of most hedge funds is to maximize return on investment. The name is mostly historical, as the first hedge funds tried to hedge against the downside risk of a bear market by shorting the market. (Mutual funds generally don't enter into short positions as one of their primary goals). Nowadays, hedge funds use dozens of different strategies, so it isn't accurate to say that hedge funds just "hedge risk." In fact, because hedge fund managers 

make speculative investments, these funds can carry more risk than the overall market.

Below are some of the risks of hedge funds:

  1. Concentrated investment strategy exposes hedge funds to potentially huge losses.

  2. Hedge funds typically require investors to lock up money for a period of years.

  3. Use of leverage, or borrowed money, can turn what would have been a minor loss into a significant loss.

Hedge Fund Manager Pay Structure 

Hedge fund managers are notorious for their typical 2 and 20 pay structure whereby the fund manager to receive 2% of assets and 20% of profits each year. It's the 2% that gets the criticism, and it's not difficult to see why. Even if the hedge fund manager loses money, he still gets 2% of assets. For example, a manager overseeing a $1 billion fund could pocket $20 million a year in compensation without lifting a finger. 

That said, there are mechanisms put in place to help protect those who invest in hedge funds. Often times, fee limitations such as high-water marks are employed to prevent portfolio managers from getting paid on the same returns twice. Fee caps may also be in place to prevent managers from taking on excess risk.

How to Pick a Hedge Fund 

With so many hedge funds in the investment universe, it is important that investors know what they are looking for in order to streamline the due diligence process and make timely and appropriate decisions. 

When looking for a high-quality hedge fund, it is important for an investor to identify the metrics that are important to them and the results required for each. These guidelines can be based on absolute values, such as returns that exceed 20% per year over the previous five years, or they can be relative, such as the top five highest-performing funds in a particular category.

Absolute Performance Guidelines

The first guideline an investor should set when selecting a fund is the annualized rate of return. Let's say that we want to find funds with a five-year annualized return that exceeds the return on the Citigroup World Government Bond Index (WGBI) by 1%. This filter would eliminate all funds that underperform the index over long time periods, and it could be adjusted based on the performance of the index over time. 

This guideline will also reveal funds with much higher expected returns, such as global macro funds, long-biased long/short funds, and several others. But if these aren't the types of funds the investor is looking for, then they must also establish a guideline for standard deviation. Once again, we will use the WGBI to calculate the standard deviation for the index over the previous five years. Let's assume we add 1% to this result, and establish that value as the guideline for standard deviation. Funds with a standard deviation greater than the guideline can also be eliminated from further consideration.

Unfortunately, high returns do not necessarily help to identify an attractive fund. In some cases, a hedge fund may have employed a strategy that was in favor, which drove performance to be higher than normal for its category. Therefore, once certain funds have been identified as high-return performers, it is important to identify the fund's strategy and compare its returns to other funds in the same category. To do this, an investor can establish guidelines by first generating a peer analysis of similar funds. For example, one might establish the 50th percentile as the guideline for filtering funds. 

Now an investor has two guidelines that all funds need to meet for further consideration. However, applying these two guidelines still leaves too many funds to evaluate in a reasonable amount of time. Additional guidelines need to be established, but the additional guidelines will not necessarily apply across the remaining universe of funds. For example, the guidelines for a merger arbitrage fund will differ from those for a long-short market-neutral fund.

Relative Performance Guidelines

To facilitate the investor's search for high-quality funds that not only meet the initial return and risk guidelines but also meet strategy-specific guidelines, the next step is to establish a set of relative guidelines. Relative performance metrics should always be based on specific categories or strategies. For example, it would not be fair to compare a leveraged global macro fund with a market-neutral, long/short equity fund.

To establish guidelines for a specific strategy, an investor can use an analytical software package (such as Morningstar) to first identify a universe of funds using similar strategies. Then, a peer analysis will reveal many statistics, broken down into quartiles or deciles, for that universe.

The threshold for each guideline may be the result for each metric that meets or exceeds the 50th percentile. An investor can loosen the guidelines by using the 60th percentile or tighten the guideline by using the 40th percentile. Using the 50th percentile across all the metrics usually filters out all but a few hedge funds for additional consideration. In addition, establishing the guidelines this way allows for flexibility to adjust the guidelines as the economic environment may impact the absolute returns for some strategies.

Here is a sound list of primary metrics to use for setting guidelines:

• Five-year annualized returns
• Standard deviation
• Rolling standard deviation
• Months to recovery/maximum drawdown
• Downside deviation
  

These guidelines will help eliminate many of the funds in the universe and identify a workable number of funds for further analysis. An investor may also want to consider other guidelines that can either further reduce the number of funds to analyze or to identify funds that meet additional criteria that may be relevant to the investor. Some examples of other guidelines include:

• Fund Size/Firm Size: The guideline for size may be a minimum or maximum depending on the investor's preference. For example, institutional investors often invest such large amounts that a fund or firm must have a minimum size to accommodate a large investment. For other investors, a fund that is too big may face future challenges using the same strategy to match past successes. Such might be the case for hedge funds that invest in the small-cap equity space. 
• Track Record: If an investor wants a fund to have a minimum track record of 24 or 36 months, this guideline will eliminate any new funds. However, sometimes a fund manager will leave to start their own fund and although the fund is new, the manager's performance can be tracked for a much longer time period. 
• Minimum Investment: This criterion is very important for smaller investors as many funds have minimums that can make it difficult to diversify properly. The fund's minimum investment can also give an indication of the types of investors in the fund. Larger minimums may indicate a higher proportion of institutional investors, while low minimums may indicate of a larger number of individual investors.
• Redemption Terms: These terms have implications for liquidity and become very important when an overall portfolio is highly illiquid. Longer lock-up periods are more difficult to incorporate into a portfolio, and redemption periods longer than a month can present some challenges during the portfolio-management process. A guideline may be implemented to eliminate funds that have lockups when a portfolio is already illiquid, while this guideline may be relaxed when a portfolio has adequate liquidity.
  

How Are Hedge Fund Profits Taxed?

When a domestic U.S. hedge fund returns profits to its investors, the money is subject to capital gains tax. The short-term capital gains rate applies to profits on investments held for less than one year, and it is the same as the investor's tax rate on ordinary income. For investments held for more than one year, the rate is not more than 15% for most taxpayers, but it can go as high as 20% in high tax brackets. This tax applies to both U.S. and foreign investors.

An offshore hedge fund is established outside of the United States, usually in a low-tax or tax-free country. It accepts investments from foreign investors and tax-exempt U.S. entities. These investors do not incur any U.S. tax liability on the distributed profits.

Ways Hedge Funds Avoid Paying Taxes

Many hedge funds are structured to take advantage of carried interest. Under this structure, a fund is treated as a partnership. The founders and fund managers are the general partners, while the investors are the limited partners. The founders also own the management company that runs the hedge fund. The managers earn the 20% performance fee of the carried interest as the general partner of the fund.

Hedge fund managers are compensated with this carried interest; their income from the fund is taxed as a return on investments as opposed to a salary or compensation for services rendered. The incentive fee is taxed at the long-term capital gains rate of 20% as opposed to ordinary income tax rates, where the top rate is 39.6%. This represents significant tax savings for hedge fund managers.

This business arrangement has its critics, who say that the structure is a loophole that allows hedge funds to avoid paying taxes. The carried interest rule has not yet been overturned despite multiple attempts in Congress. It became a topical issue during the 2016 primary election.

Many prominent hedge funds use reinsurance businesses in Bermuda as another way to reduce their tax liabilities. Bermuda does not charge a corporate income tax, so hedge funds set up their own reinsurance companies in Bermuda. The hedge funds then send money to the reinsurance companies in Bermuda. These reinsurers, in turn, invest those funds back into the hedge funds. Any profits from the hedge funds go to the reinsurers in Bermuda, where they owe no corporate income tax. The profits from the hedge fund investments grow without any tax liability. Taxes are only owed once the investors sell their stakes in the reinsurers.

The business in Bermuda must be an insurance business. Any other type of business would likely incur penalties from the U.S. Internal Revenue Service (IRS) for passive foreign investment companies. The IRS defines insurance as an active business. To qualify as an active business, the reinsurance company cannot have a pool of capital that is much larger than what it needs to back the insurance that it sells. It is unclear what this standard is, as it has not yet been defined by the IRS.

Hedge Fund Controversies 

A number of hedge funds have been implicated in insider trading scandals since 2008. One of the most high-profile insider trading cases involve the Galleon Group managed by Raj Rajaratnam.

The Galleon Group managed over $7 billion at its peak before being forced to close in 2009. The firm was founded in 1997 by Raj Rajaratnam. In 2009, federal prosecutors charged Rajaratnam with multiple counts of fraud and insider trading. He was convicted on 14 charges in 2011 and began serving an 11-year sentence. Many Galleon Group employees were also convicted in the scandal.

Rajaratnam was caught obtaining insider information from Rajat Gupta, a board member of Goldman Sachs. Before the news was made public, Gupta allegedly passed on information that Warren Buffett was making an investment in Goldman Sachs in September 2008 at the height of the financial crisis. Rajaratnam was able to buy substantial amounts of Goldman Sachs stock and make a hefty profit on those shares in one day.

Rajaratnam was also convicted on other insider trading charges. Throughout his tenure as a fund manager, he cultivated a group of industry insiders to gain access to material information.

New Regulations for Hedge Funds

Hedge funds are so big and powerful that the SEC is starting to pay closer attention, particularly because breaches such as insider trading and fraud seem to be occurring much more frequently. However, a recent act has actually loosened the way that hedge funds can market their vehicles to investors. 

In March 2012, the Jumpstart Our Business Startups Act (JOBS Act) was signed into law. The basic premise of the JOBS Act was to encourage funding of small businesses in the U.S. by easing securities regulation. The JOBS Act also had a major impact on hedge funds: In September 2013, the ban on hedge fund advertising was lifted. In a 4-to-1 vote, the SEC approved a motion to allow hedge funds and other firms that create private offerings to advertise to whomever they want, but they still can only accept investments from accredited investors. Hedge funds are often key suppliers of capital to startups and small businesses because of their wide investment latitude. Giving hedge funds the opportunity to solicit capital would in effect help the growth of small businesses by increasing the pool of available investment capital.

Hedge fund advertising entails offering the fund's investment products to accredited investors or financial intermediaries through print, television and the internet. A hedge fund that wants to solicit (advertise to) investors must file a “Form D” with the SEC at least 15 days before it starts advertising. Because hedge fund advertising was strictly prohibited prior to lifting this ban, the SEC is very interested in how advertising is being used by private issuers, so it has made changes to Form D filings. Funds that make public solicitations will also need to file an amended Form D within 30 days of the offering’s termination. Failure to follow these rules will likely result in a ban from creating additional securities for a year or more.